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Game Theory, Behavioral Finance, and Investing: Part 2 of 5

In Part 1 of this series, I set the stage for a discussion of behavioral finance and game theory as they pertain to how market participants behave. In Part 2, I expand upon some of ways that individuals and institutions behave in ways that can be explored from this perspective.

Giving People What They Want

One of the most striking features of the capital markets of the recent year or two has been the ‘Las Vegas’ feeling to much of the action in the markets. There has been tremendous excitement around IPOs of companies including Zynga (ZNGA), Groupon (GRPN), and most notably Facebook (FB). The hoopla around the Facebook IPO, in particular, is without precedent. Why do the financial media and corporate management work together to create this frenzy? The answer is simple: people buy it. If investors ignored the carnival atmosphere around these firms, we wouldn’t see this kind of media. If people say that they want to invest in solid well-run profitable firms, but clearly signal that what they are actually buying is shares in IPOs of companies with enormous dreams but untested business models, we know what Wall Street will provide. If investors seem to be seeking investments that behave like lottery tickets, it is perfectly rational for venture capitalists to fund such companies and to rapidly take them public. I view the marketing of Facebook’s IPO as perfectly executed to exploit behavioral biases. I am not a conspiracy theorist, but even the trading delay on the day of the IPO helped to bring the frenzy to own shares to a fever pitch. The Facebook IPO and others like it suggest that Wall Street is very effectively playing a game that many investors do not really understand.

Conflicts of Interest and Agency Problems

When one person is hired to act in the interests of another, this is referred to as an agency relationship. A realtor is a common example of an agent. When there are conflicts of interest between an agent and the person he or she is serving, this situation is referred to as an agency problem. There are a number of well-known agency problems for investors.

Share Buybacks

I have recently written about the fact that much of the rally in stocks this year is apparently largely due to share buybacks in which public companies purchase their own shares. This has a very interesting game theory dimension. Executive corporate managers in the U.S. receive a large fraction of their compensation via stock options. I discussed this in a 2010 article:

Research by Kevin Murphy at USC analyzed the enormous change in executive compensation through the 1990s and found that stock options had become the largest single component of executive compensation by the end of that decade. In a more recent summary study, Michael Jensen and Kevin Murphy discussed this trend and explored its implications. They found that the average CEO received 24% of his or her compensation in the form of stock options in 1992, but by 2000 that fraction had risen to approximately 50% of total compensation.

This enormous and rapid change in how executives are paid leads to new incentives for management that may or may not benefit investors. While it may be entirely coincidental, share buybacks have the direct and immediate impact of increasing the value of stock options, but the long-term benefit to investors is in question. We should not be surprised that management changes its behavior in response to changing incentives. What is surprising is that there is not more attention paid to how investors need to change their choices to reflect the dynamic relationship between their interests and that of corporate management.

IPOs

There are also apparent agency problems in the process by which a company goes public, to the extent that management is also among the major beneficiaries of the IPO. On one hand, management acts as an agent for current and future investors, with the responsibility to effectively manage the firm’s capital. On the other hand, management also has an incentive to achieve the highest payout for itself and early investors. Facebook is a case in point. Certainly Mark Zuckerberg is less rich than he was when the stock had a higher price, but the company is now public with a market capitalization of $40 Billion and a very high price-to-earnings ratio of 65. The Facebook IPO has generated enormous gains for many pre-IPO investors, even as those who purchased the publicly-listed stock in the IPO have seen the price drop 50% since.

What This Means

In a perfectly rational world of efficient capital markets, companies go public because they need access to capital. Managers act wholly in the best interests of investors. In the real world, IPOs often seem packaged and marketed just like consumer goods and, really, that should come as no surprise. Furthermore, investing in the real world is rife with agency issues and I have discussed just a couple. The lesson for investors is to realize that only you and/or an advisor with fiduciary responsibility have the incentives to act purely in your best interests.

In Part 3, I explore a number of well-known behavioral biases through which investors act in ways that are likely to reduce their overall wealth. In other words, our behavioral quirks drive us to act against our own long-term best interests.

About Geoff Considine

After earning his Ph.D. in Atmospheric Science, Geoff worked for NASA for 3 years, leaving to become a quantitative analyst developing trading and portfolio management solutions for Aquila Energy. Leaving Aquila in 2000, Geoff became a consultant focusing on quantitative methods in portfolio management. Geoff founded Quantext in March 2002.
Geoff has published commentary and analysis in a range of publications, including Advisor Perspectives, Financial-Planning.com, and Horsesmouth.com.
Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com (http://www.foliofn.com)).
Neither Quantext nor Geoff Considine is an investment advisor.

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